Watson Pharmaceuticals: Financial Gauge Analysis for the June 2010 Quarter

Watson Pharmaceuticals, Inc., (NYSE: WPI) earned $0.57 per diluted share on a GAAP basis in 2010's second quarter. This result was 28 percent more profitable than Watson's earnings per share of $0.45 in the same quarter of 2009.

A previous article examined Watson's Income Statement for the June quarter in some detail. Reported earnings were $0.03 more than the $0.54 per share we had forecast.

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value. This post reports on the metrics for Watson Pharmaceuticals and the associated financial gauge scores. The metrics were calculated using data from Watson's current and historical financial statements, including those in the latest 10-Q report.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Watson Pharmaceuticals produces and distributes generic and, to a lesser extent, branded pharmaceuticals. Watson earned $222 million in 2009, down from $238 million in 2008. Revenue increased from $2.5 billion to $2.8 billion. The company's current market capitalization is approximately $5.5 billion.

Additional background information about Watson and the business environment in which it is currently operating can be found in the look-ahead.

Mergers and acquisitions pose a challenge to us at GCFR because a major deal can lead to both temporary and longer term changes to the company's financial results. Comparisons with the past, a key element of our approach, can be misleading. Temporary changes include unusual revenue growth and large restructuring expenses. In addition, it's not unusual for one transaction to be followed by others, such as asset divestitures that don't conform to the new organization's priorities.

For these and other reasons, extra caution has to be taken when evaluating a company in the immediate aftermath of a merger or acquisition. It is often prudent to "let the dust settle" before drawing any far-reaching conclusions.

With this caveat in mind, Watson Pharmaceuticals' latest quarterly results produced the following changes to the gauge scores:

The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary. Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.

In large part due to the Arrow acquisition, Watson increased its Long-term Debt to nearly $1.2 billion, a record dollar amount for the company. Watson issued $450 million in five-year notes and $400 million in 10-year notes.

Although the debt level jumped, today's value for the LTD-to-Equity ratio is much less than it was at other times in the company's history. Fitch Rating recently raised its rating of Watson's debt, from BBB- to BBB, noting that "Watson often starts paying down its debt quickly following an acquisition. The agency expects the company to continue to reduce debt for the rest of this year."

Liquidity is ample. Working Capital increased from $890 million to $1.0 billion during the June quarter, and Current Assets are a more-than-comfortable 2.3 times Current Liabilities.

The number of days of Inventory is up from last year when measured by the Cost of the Goods Sold. We prefer to see Inventories getting leaner because it's not efficient to tie up a lot of cash in inventory. In addition, a decreasing proportion of Finished Goods in the Inventory is generally preferable to an increase. However, there are exceptions to these rules-of-thumb: an Inventory buildup to support new products or marketing efforts would be understandable.

The Days of Sales Outstanding and the Cash Conversion Cycle Time seem to have stabilized after earlier increases. As is the case for Inventory, lower numbers tend to suggest more efficient use of cash.

Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters. The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.

Higher Revenue and Net Income added three points to the Growth gauge score, but negative Cash Flow growth and a Revenue/Assets ratio lower than it was last year kept the score in single digits.

The Arrow acquisition boosted Revenue growth (29 percent in the second quarter). We would not assume this growth rate will be sustained.

The ratio of Revenue to Assets has been fluctuating. The increase in the June quarter is a substantial step in the right direction.

Lower Cash Flow from Operations in the last four quarters, when compared to the four previous quarters, would normally be a significant concern. However, it appears to have been weighed down by one-time charges (acquisition and restructuring costs).

Abnormal tax benefits in the June 2010 quarter contributed to the healthier Net Income growth rate.

The latest results were not sufficient to move the Profitability gauge a meaningful amount. The score remains weak.

The Operating margin was stable over the last year. We would like to see Operating Expenses declining as a percentage of Revenue.

The Return on Invested Capital moved up nearly a full percentage point in the last quarter, but the gauge was unimpressed. ROIC is below what it was last year at this time.

The Free Cash Flow ratio became slightly weaker.

A one-year rise in the Accrual Ratio can be a warning of Earnings Quality degradation. In this case, the $1 billion in Cash Used for Investments in the fourth quarter of 2009 has distorted the figures.

Watson's share price slipped 3 percent in the June quarter, which helped bring down the Price-to-Earnings and Price-to-Sales ratios in the last three months. However, the declines were not substantial enough to boost the Value gauge score.

The share price is now over $44, which will weigh on the Value gauge in the third quarter unless earnings and cash flow grow at more robust rates.

Watson now has two quarters under its belt after the Arrow acquisition. Although there were encouraging data in the latest results, earlier special items and the surge in the company's shares kept the gauge scores low. The gauges, which are backward looking, need to see sustained earnings and cash flow growth.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
PRO Alerts is our flagship product for individual investors who want to be faster
and smarter about their stocks. To learn more about it, click here.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!